Finance

The Untaxables

Before Congress revisits the Internet-sales issue, states are
developing a simpler and more uniform tax-collection process.

In May, the announcement by Sears that it plans to buy Lands' End set the retail industry abuzz. Since then, analysts have been speculating about how the department store chain will merge its old-line business with a mail-order and online company, and what that combination portends for the future of retailing.

Whatever it might mean to the business sector, the Sears-Lands' End deal suggests something entirely different to the 45 states and 7,500 localities that levy sales taxes: the possibility of splitting a pot of $90 million a year--and, potentially, hundreds of millions more.

The $90 million represents roughly the amount of annual sales-tax revenue that Wisconsin-based Lands' End currently does not collect on its $1.6 billion in sales of fleecy sweaters, weekend luggage and the like. That's because in 1992, the U.S. Supreme Court ruled that states cannot compel a company to collect taxes for them if that company has no physical presence in a state. Lands' End has no physical presence-- no nexus--in 46 states.

Sears, on the other hand, operates retail stores in all 50 states. Richard Pomp, a law professor at the University of Connecticut, raises his voice a notch or two to get his point across: The Sears purchase of Lands' End "has enormous ramifications for all the states." Not only might Lands' End have to collect sales taxes from its customers, he says, but the deal also "brings to the fore the continued erosion and emasculation of the sales tax." The high-profile retail merger could, Pomp suggests, carry with it the momentum for fixing the sales- tax problem.

A two-year-old effort by a majority of sales-tax-levying states--the Streamlined Sales Tax Project and its year-old progeny, the Streamlined Sales Tax Implementing States--is poised for a big push toward that goal this winter. Its worker-bee efforts, which have been considerable and surprisingly effective this past year, could also be enhanced by a California tax department opinion issued last September on the taxability of Borders Books' online sales. That opinion seems to foreshadow the sales-tax question in the Sears-Lands' End deal. The California Department of Equalization took note of the way online buyers could return books to bricks-and-mortar stores for refunds or store credits and was of the opinion that Borders Online "was obligated to collect and remit use tax" from its California customers.

The decision, which so far has not been appealed by Borders Online, generated a lot of interest in the tax world when it first came out. In light of the Sears deal, it is again the focus of attention as a possible breakthrough on the sales-tax front.

For many states and municipalities, a turnaround of the much-eroded sales-tax base can't come too soon. Although the issue was largely sidelined during the revenue-rich 1990s, state budget deficits and the desperate need to raise revenue are pushing it front and center again.

During the past two decades, the sales-tax base has been declining steadily relative to state personal income. The failure by states to expand the sales-tax base to keep up with a services-dominated economy accounts for a good portion of that slippage. But untaxed, remote-site sales of goods have also been chipping away at those revenues.

A recent study put the overall sales-tax losses from Internet sales at $13.3 billion in 2001 and forecast a tripling of that loss to $45.2 billion in 2006. When the authors of the study, William F. Fox and Donald Bruce of the University of Tennessee, Knoxville, measured future revenue declines from Internet sales, they put state losses at anywhere from 3 to 10 percent of total state tax collections by 2011.

In states that don't levy a personal-income tax--such as Texas--the money drain is serious stuff. The potential revenue loss by 2011, the study found, will hit almost 10 percent of total expected tax collections. To make up for that revenue loss, Texas would have to raise its current statewide sales-tax rate of 6.25 percent to 7.86 percent.

To turn the sales-tax situation around, the states are working on the core of the argument behind the 1992 ruling in Quill Corp. v. North Dakota, the logic of which is also one of the main reasons behind the U.S. Congress' refusal to mandate collection of the tax by remote-site retailers: The sales tax is overly complex and complicated, with hundreds of exemptions, special rules and differing definitions that vary from state to state and among localities within those states. Collecting the tax, the courts ruled and congressional leaders confirmed, was an overwhelming burden on out-of-state retailers.

The multi-state streamlining effort--the SSTP and SSTIS--began life as an effort to lift that burden. The overall goal of the project, which now has as its members state legislators, tax administrators, governors' staff and private-sector retailers from nearly 40 states, is two-fold. "One of them is sexy and a little bit problematic," Bruce Johnson, Utah's tax commissioner and co-chair of the SSTIS, says of the group's hope of influencing Congress to require remote-site sales- tax collection. "The other is just plain good business. States would like to make it simpler, easier and less expensive for retailers to collect the tax."

Even without the complication of Internet and mail-order sales, the sales tax is an expensive mess to collect and to regulate. For businesses with hundreds of stores around the country, such as Sears and Safeway, the variety of definitions and exemptions edge close to the incomprehensible. For state regulators, who assess penalties on retailers for incorrect collections, this aspect of administering the tax is an exercise in frustration.

Simplifying the system, however, is a challenge. "Many of the questions that the implementing states are trying to work out may seem quite ridiculous, like 'Are marshmallows food or candy?'" says Illinois Senator Steven Rauschenberger, who co-chairs a committee on taxation for the National Conference of State Legislatures. "The monumental task facing the states is trying to rewrite a series of arcane sales-tax laws so that they reflect the constantly changing nature of today's economy."

In the past year, the multi-state effort has made remarkable progress through the dense thicket of definitions. For example, the groups have come up with a definition of soft drinks: They are beverages that contain less than 50 percent fruit juice. Any beverage with 50 percent or more fruit juice is a food. As Diane Hardt, Wisconsin's tax administrator, explains the ramifications, Wisconsin doesn't tax food and under its current definition, any beverage that is 100 percent fruit juice is not taxed; any beverage below 100 percent is not a food and is taxed. So, if Wisconsin adopted the uniform definitions, it would only be able to tax soft drinks that are 50 percent or less fruit juice, and it would lose the revenue from any drinks that are between 50 and 99 percent juice.

Multiply the soft-drink issue times thousands of other food categories, in addition to clothing, software and digital goods, and it's clear that a lot of delicate and tedious compromise is involved. "We took on the hard ones," says Hardt, a co-chair of the SSTP. "We knew we had to come up with these first because they most affect e- commerce and mail-order retailers." Representatives from companies such as Wal-Mart, Amazon.com, Sears and Safeway have been at the monthly meetings and have helped work on definitions.

Hardt also points out that the definitions are not an attempt to tell a state what it should or should not tax. Only a legislature can make that decision. For states that sign on, however, legislators have to pick and choose from the streamlined definitions. "Revenue may sway one way or another to get to that definition," Hardt says. "We are working to minimize those revenue sways, but there's no doubt we are all going to have to change."

The streamlining package is scheduled to be presented at the NCSL and National Governors' Association annual meetings in July and further refined to be ready by early fall. At that point, states can begin looking at their tax laws, seeing where changes might be necessary to bring the state into compliance and readying an approach for legislative consideration in their 2003 sessions.

So far, 31 states, from Texas and Ohio to Illinois and Virginia, have passed SSTP or SSTIS model legislation expressing a commitment to simplification and approving participation in the streamlining process. "As we move forward, we expect additional states to join the effort," says Tennessee Representative Matt Kisber, co-chair of the SSTIS. "In the end, we should have a system that provides much-needed bureaucratic relief to retailers, and states will preserve a revenue stream that is vital to maintaining the basic level of government services."

Step two--and the second goal of the process--is to take the fact of simplification to Congress and ask that body to require remote sellers to collect the tax. Although simplification is aimed as much at mail order as at Internet retailers, the whole movement has been tied to the extension of the tax moratorium on the Internet. Sales taxes are not part of that moratorium. Nonetheless, there is some anticipation by many in Congress, as well as in the states, that this Congress will look at the sales-tax issue when the moratorium is set to expire in November 2003. Project leaders say they hope to have five or more state legislatures act to incorporate the simplifications by November of next year. "At that point, we can go to Congress," says Utah's Johnson, "and say we have recognized the problem in Quill, solved it and it is now appropriate for federal legislators to say that if a state complies with the agreement requiring simplicity and uniformity, it is not an undue burden on interstate commerce to require remote sellers to collect the sales tax."

"That's the scenario we're working on now," says Neil Osten, who follows the issue for NCSL. Although, he adds, "we anticipate bumps in the road." Nevertheless, streamlined-tax leaders are keeping their eyes on the main chance. "States need to make their sales tax simpler and easier," says Charles D. Collins, who heads up North Carolina's Department of Revenue. "That's what they can control."